Treasury workshopped dealing with recession in 2003-04

The Treasury has released papers, under a Freedom of Information request, documenting how it's Executive Board considered dealing with a possible recession in 2003-04. The issues raised in the papers figured large in Treasury's advice to the Rudd Government in 2008, when considering a response to the global financial crisis.

• Background paper: History of discretionary policy in Australia
• Policy manual: A user's guide to discretionary fiscal policy
• Pro-forma briefing: Response to a slowing economy
• Modelling paper: TRYM preliminary paper-A permanent fiscal expansion

David Uren reports in The Australian that "The workshops were conduct­ed amid high secrecy and marked a radical turn for Treasury, which had long been opposed to the use of stimulus measures. Then Treasury secretary Ken Henry believed his department had failed to provide the Keating government with adequate advice following the 1991-92 recession, which resulted in a stimulus program being developed in the office of then treasurer John Dawkins with minimal departmental input. The Treasury papers say that package was a failure, with infrastructure spending not starting until the mid-1990s, by which time the economy was surging ahead."

Background to Treasury's paper

At the time Treasury was putting these papers together, growth was alright but below potential and the outlook for the economy was quite uncertain. The severe drought had removed about 1 percentage point of growth from GDP and the international risks were on the downside, as illustrated by these comments from the economic outlook from the 2003-04 budget papers.

Despite the positive domestic outlook, the performance of the Australian economy over the next year will be heavily influenced by international developments. After a protracted period of weakness, and despite substantial policy stimulus, a sustained global recovery has not yet taken hold. The most likely outcome is a gradual improvement in the global economy with world growth expected to be around 3 per cent in 2003, rising to around 3½ per cent in 2004. Trading partner growth is expected to be around 2½ per cent in 2003 and 3 per cent in 2004.

Tempering this outlook, however, is a confluence of pre-existing, and some new, downside risks to the international economic outlook. There are economic risks around growth prospects for the major economies, and financial risks around financial systems in Japan and Europe and financial markets more generally. On top of this there are geopolitical risks around the situation in the Middle East and North Asia and, more recently, risks associated with the spread of Severe Acute Respiratory Syndrome (SARS). While conditions may improve quickly once some of the current uncertainty dissipates, many of the pre-existing international risks will remain. Many of these risks are due to deep-seated structural problems in the major economies, so it is likely that it will take some time before they abate. Until then, they cloud an otherwise healthy outlook for the Australian economy.

Key considerations in the use of fiscal stimulus

Key points from the papers include:

• The economy is often in recession before policy makers or economic commentators realise it.

• Policy decision making is is undertaken largely in a 'fog' of uncertainty with limited reliable information. This increases the chance of policy error.

• As a period of economic weakness is unfolding, it is difficult to predict how deep it will be or how long it will last.

• It  is therefore necessary to design discretionary policy responses recognising that, when such a policy is being proposed and implemented, the policy maker will be uncertain about both the severity and the duration of the economic weakness that is currently being experienced. 

• This is one reason why discretionary monetary policy is often advocated in preference to discretionary fiscal policy; because of its relative flexibility and the capacity for discretionary monetary changes to be unwound relatively quickly, if  that  proves advisable.

• For fiscal policy, the implementation lags are often long due to: design of the intervention; getting agreement through both Government and Parliamentary processes; and putting in place the logistics or delivery aspects of the policy.

• These long lags may mean that fiscal policy can become pro-cyclical (adding to the upturn) rather than its original counter-cyclical intention to support the economy when it is below potential.

Potential impact of discretionary fiscal policy

Treasury envisages that each of the following policy actions would add around ½ percentage point to growth in a given  year:

• a temporary 150 basis point reduction in the cash rate—this action would have no lasting effect on the budget or marked impact on Commonwealth net debt levels over time;

• a temporary ½ per cent of GDP boost to discretionary spending—this would detract from the budget position by around ↓ per cent of GDP in the first year after the policy change but because of its small and once-off nature would have no marked impact on the  Commonwealth net debt to GDP ratio over time;

•  a permanent tax cut of 1 per cent of GDP would boost growth in the year of the policy change—however, this would see a deterioration of the budget position of around ¾ per cent of GDP over time.

Treasury notes the following as relevant considerations in the use of discretionary fiscal policy:

• Tax cuts have a smaller impact than government spending on activity, as they are an indirect form of stimulus, feeding into disposable income, some of which is usually saved by taxpayers.

• Credible permanent tax cuts are more likely to raise private spending than temporary tax cuts, as they are more likely to raise a taxpayer's expectations of their expected life-time earnings.

• Even a temporary shift in GDP away from its potential could provide a justification for some discretionary fiscal action—however, the serious recognition and implementation issues that we have outlined suggest that significant discretionary action should be reserved until the economy is judged to be some distance from potential in practice, some assessment is also required as to the risk that the economy is not where it is currently judged to be (or will be in the immediate future) and therefore the likelihood of policy error.

• The level of the output gap will not be the only signal for discretionary action.  The  speed at which the economy appears to be deteriorating should also influence the policy response.

Treasury also notes that the issue of recognition lags and other implementation considerations leave open the real possibility of policy error through the implementation of pro-cyclical discretionary policy. However, the risk of a pro-cyclical policy error must be balanced against the counter proposition of a significant recession in the face of no discretionary action.

Appropriate fiscal response to a potential recession

Treasury considered a three stage response that related to the output gap—the gap between potential and actual GDP—and would be implemented as confidence of the likely outcome without discretionary policy action increases.

Stage 1 involves responding to the expected slowing in growth and the risk that the international economy will result in even lower growth to the Australian economy.  

• Fiscal policy should move from being mildly contractionary to broadly neutral
• Monetary policy should seek to be expansionary through a reduction in the cash rate by 50 basis points

Stage 2 involves responding to a more pronounced slowing in the economy as possibly signalled by a negative quarter of GDP growth with a more aggressive policy.

• Monetary policy could move more aggressively than outlined in Stage 1 with interest rates further reduced by another 100 basis points
• Fiscal policy will become more accommodative through the automatic stabilisers. Temporary discretionary fiscal spending in the order of $3 to 4 billion in 2003-04 could be examined although it is not an essential part of the policy response. Discretionary fiscal action would look to bring forward private sector consumption and investment.

Stage 3 involves responding to a sustained slow down in the economy as signalled by unemployment reaching above, say 7 per cent, before year end 2004. The unemployment rate could be above 7 per cent after as few as three quarters of very low growth.

• Monetary policy would again look to be expansionary with further reductions in interest rates. The impact of further rate cuts may begin to progressively decline well before the nominal cash rate approaches zero.
• At this stage in the cycle significant fiscal easing may be warranted to address the burgeoning output gap and help restore something like normal levels of activity.  The ideal would be an 'old style' Keynesian attempt to replace falling private consumption and investment with government spending.  Additional stimulus of up to 2 per cent of GDP could be added to activity in the form of one-off discretionary items. This would be expected to add around 1 to 2 per cent to growth between 2003-04 and 2004-05 while maintaining net debt to GDP levels at below 10 per cent of GDP (depending on the mix of fiscal measures).